The Advice of Others

TLT-options-tradeFor those of you who are familiar with the iShares 20+ Year Treasury Bond ETF (TLT), you’re probably looking at that chart and thinking: “no friggin’ way did TLT jump 24% in a day.” And you’d be right. But none the less, I made 24%+ after commissions on a TLT trade that I exited this afternoon.

The secret behind this of course: options. And the reason I took this trade in the first place is because of a seasonal trend in bonds that often happens around the same time of every month.

There are a lot of finance blogs out there, and many bad ones (including this one? 🙂 ). There are a few people I really respect though, and one of them is Jay Kaeppel. His ‘hobby’ is discovering seasonal trends in the markets, and I’ve read his book on the subject, and enjoy his blog posts about seasonal and recurring patterns in trading. One pattern that sounded very interesting was a bump in bond prices at the end of many months (you can read about it here).

But how to play it? I’m not going to invest directly in bond futures, and in fact my brokerage doesn’t offer that. I can however buy an ETF that tracks bond futures. But TLT is a pretty low-volatility ETF. It actually has too little volatility to justify a swing trade with the position size I was envisioning. Even a winning trade might generate a loss after commissions. I could however trade options on stocks and ETFs with my brokerage. This allowed me to bring more risk/reward to the transaction. So that’s what I did.

I wanted to risk about $200 or so in hopes of making the same amount or more. I’ve learned (from Jay’s site and books I’ve read) that a good way to trade stock options on the long side is this:

• Pick an expiration date that is at least a month beyond what you think your exit date will be. This reduces the amount you lose in time premium as the expiration date gets closer.

• Pick a strike price that is firmly “in the money”. TLT opened on Friday around $120, so I bought a call with a strike price of $118. Ideally, I’d pick an option with a strike price that was close to where I’d place my stop loss. Sometimes that’s not practical.

Options with these attributes have a higher delta, and will track the underlying stock/etf price more accurately than would an out of the money option, or one with a nearer expiration date. If the price were to move the wrong way, the option will still have plenty of value and it will be easy to offload at a respectable price. No one wants an out-of-the-money option that expires in five days!

The downside is that these long-expiration, in-the-money options are more expensive. A single contract was priced at $410, and I bought two of them. If I lost $100 per contract, that was my sign to get out.

With options, the upside can be big, but so can the downside. If TLT had lost 2%, I would have lost several hundred dollars. Just because you need less money to enter a position does NOT mean you can ignore your downside risk. I’ve entered into some option trades being fully prepared to lose the entire thing. You must keep your position sizes polite and demure.

Fortunately, this trade went the other way, and I made $103 x 2 before commissions. Nice!

Now if you’ve actually read Jay’s post, you’ll see it says to hold for more than two days. I got out early, and I have no regrets. I made the money I’d hoped, and I have a sneaking suspicion that today’s bump won’t last. So I’ll take my profits while I can.

Bonus: this makes up for (and then some) the bad trade I had in gold, which stopped out this morning. Win some, lose some, and hopefully win more than ya lose!

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